The following points highlight the top two sources of growth of firms. The sources are: 1. Internal Growth 2. Mergers.
Source # 1. Internal Growth:
Many firms become large by generating internal growth. Marks and Spencer is an example. It started as a market stall selling clothes and still does this, though it has also diversified into other products. Other firms have also grown by diversifying within the same industry. The Ford Motor Company started by producing only one car model; now it produces not only a wide range of cars, but also trucks and other related products.
Such diversification makes it possible for firms to become large while still remaining in the same business. One reason why firms grow large is that, in some cases, their average costs fall in the long run as the firm produces more. In such a situation has any firm producing only a few goods will be at a disadvantage compared to its competitors because its costs will be higher. Where costs vary with output in this way, firms tend to grow until they produce a level of output where costs are low.
Source # 2. Mergers:
Some firms are content to remain small. Their owners are satisfied with reasonable profits and are not willing to deal with the problems which may arise if the firm is to grow. On the other hand, some entrepreneurs want to be big. They are constantly seeking new opportunities for growth and are willing to struggle in order to take over other firms, even though these may resist. For this group big is beautiful.
Sometimes, firms take over their suppliers or their customers. This is called vertical integration. Examples would include a brewing company which bought hop fields or took over a firm owning pubs. Vertical integration can be either forward or backward. Firms integrate backwards to obtain control over the raw materials and components they need.
Forward integration gives them control over marketing the products they make. Another reason for vertical integration is that it reduces transactions costs. As the phrase implies, these are the costs involved in buying and selling goods. Uncertainties over demand and supply conditions can lead to costly hogging over the terms of a contract between firms. This hogging can be eliminated if one firm merges with the other.
Horizontal integration occurs when a firm buys another in a completely different industry as, for example, when a tobacco company buys an insurance company or an engineering firm joins a company building houses. Mergers between very different firms lead to the formation of conglomerates.
One reason for diversified integration is that it reduces risk. If one product or firm within the conglomerate fails, profits from the others will allow the firm to continue in business. Another reason is that diversified firms within a conglomerate possess assets which can be shared.
One may have technological know-how, another spare physical capacity and a third may have marketing or managerial expertise. Sharing such assets can bring substantial benefits to the group. Moreover, diversification can reduce to transactions costs if quick managerial decisions within a firm replace expensive negotiations with other firms.